Arithmetic Trumps Eurozone Politics

In both Greece and Spain, tens of thousands of people turned out in the streets for protests against the austerity measures being imposed by their governments. These measures are necessary in order for these governments to stay in the good graces of the Troika who controls the rescue funds, the European Central Bank (ECB), the European Commission and the IMF. The Troika wants to see these countries hitting their budget deficit targets as a condition of being eligible to receive continued to support.

The problem with the Troika’s agenda is that the budget cuts and tax increases they demand as a condition of continued support lead to a further contraction of the economies of Greece, Spain and other crisis countries. When the economies contract, tax collections fall and spending on transfers such as unemployment insurance increases. This leads to larger deficits, causing the countries to again fall below the deficit targets.

While imposing austerity demands on the crisis countries might be great sport in Berlin and Brussels (you get to show how tough you are) it is ruining millions of lives in the crisis countries. The New York Times had an article on Spain last week in which it reported the country’s 25 percent unemployment rate has pushed many formerly middle-class people to sleeping in the streets and eating out of garbage cans. It reported that many restaurants and grocery stores are now putting locks on their dumpsters to keep people from eating from them. There are similar horror stories in the other crisis countries in the eurozone.

The absurdity of this suffering is that it is entirely preventable. If the ECB were determined as a matter of policy to promote a higher rate of wage growth and inflation in Germany then it could facilitate the sort of growth that could bring the unemployment rates in Spain, Greece and elsewhere to more normal levels.

The basic story is very simple. As a result of the fact that Germany had strong productivity growth in the last decade, coupled with sharply constrained growth in labor compensation, meant that the price of German goods fell substantially relative to the price of goods produced elsewhere in the eurozone, most notably the current crisis countries.

This divergence in relative prices led the crisis countries to have large trade deficits with Germany. In the last decade these deficits were supported by lending from German banks. This flow was most important in the cases of Spain and Ireland where the lending helped to fuel huge housing bubbles.

When the bubbles burst, the lending stopped, but the trade imbalances remained. If a country has a trade imbalance then it must either have negative private savings, negative public savings (i.e. a budget deficit) or some combination. These countries are not going to have negative private savings, since consumption and investment are both being held back by the collapse of the housing market and the economy. This means that as a matter of arithmetic, the large trade deficit will largely correspond to the large budget deficits that upset the troika.

In the short-term, the trade deficits and the implied budget deficits will have to be supported by lending from the IMF, the ECB and the various bailout funds they create. The longer-term fix to the situation requires that prices in Germany rise relative to prices in the crisis countries.

The easy way to accomplish this result is to have prices in Germany rise more rapidly, for example 4-5 percent annual inflation for a number of years. The harder way is the path currently being followed. The hope is that with enough unemployment, wages and prices will eventually drop or at least not rise as rapidly as in Germany, allowing for a return to competitiveness eventually.

The costs of going this route are the people going hungry and homeless in Spain and Greece. It is a generation of young people being denied the opportunity to start a career. It is a generation of older workers thrown out of labor force with at best a meager pension to support them in a premature retirement.

We are talking about tens of millions of lives being ruined, but economists tend to prefer dollars and cents. If we look at the IMF calculations of the output gap in Spain (averaging their 2007 and 2012 estimates of potential GDP), the lost output has already been more than 20 percent of GDP. This would correspond to more than $3 trillion in the United States. With little prospect of much improvement on the horizon, the loss in the next four years could easily double this amount. That would imply the equivalent of $25,000 being thrown in the garbage for every man, woman, and child in the United States.

Spain and the other eurozone crisis countries are being forced to suffer enormous pain just so that Germany doesn’t have to see the same sort of inflation rates it experienced in the prosperous 60s. This is close to madness. If there were any justice in the world, people across Europe would grab there pitchforks and go after the flat-earthers with PhDs. Unfortunately, the people who have wreaked so much havoc across the continent will likely continue to call the shots, at least for the foreseeable future.

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.